From Mr David Mackie and Mr Malcolm Barr. FT

Sir, The European Central Bank feels vindicated over its views on private sector involvement, as highlighted by Athanasios Orphanides, governor of the central bank of Cyprus (“Time to jettison the plans to hit Greek creditors”, January 6). Ahead of the decision in July to impose PSI in Greece, the ECB warned that it would be very disruptive. And that has proved to be the case. But the central bank has failed to spell out a viable alternative.

The key question is how does the region ensure that a nation in receipt of financial assistance undertakes appropriate fiscal and structural adjustments? One option is for there to be a credible limit to that assistance. Given that it is difficult to deny financing for the budget deficit, such a limit implies that bondholders may not be paid back in full. The other option is to have an effective political means of ensuring compliance.

A key motivation for the Greek PSI has been to slow the pace of substitution of official liabilities for market debt, and hence retain a credible threat that official support has its limits. It became clear last spring that if Greece were given a second package on the same terms as the first – whereby official loans not only financed the ongoing deficit but also paid off all maturing debt – then it would not be long before there was no market debt left.

All of Greece’s sovereign liabilities would be owed to the official sector. By October a decision was made to impose a more aggressive PSI which delivered genuine debt relief. But the desire to keep a significant amount of market debt in place in order to provide appropriate incentives remained.

There is a case for abandoning Greek PSI for the short-run good of the region as a whole. But in the absence of PSI, Greek sovereign liabilities will move into official hands rapidly, and the question of incentives will remain critical. It is doubtful that effective political means to ensure Greece pursues reform are in place.

Mr Orphanides suggests official loans are granted on increasingly lenient terms. One means to encourage Greek adjustment would be to make those financing costs more clearly dependent on achieving specific policy objectives.